WHAT YOU SHOULD KNOW
When you tune into the news and they start talking about how the stock market did that day, do you tune out? Perhaps you sit and listen but you have no idea what they’re talking about. They might as well be speaking in a foreign language.
When you tune into the news and the host is speaking about how the stock market did that day, do you sit and listen but you have no idea what they’re talking about? Does it seem like they might as well be speaking in a foreign language?
With today’s post, we kick off the Explain It To Me segment, an Introduction the investment world. with an explanation of just what “the Market” means.
First thing first, when someone mentions “the market” it usually refers to the U.S. stock market, as measured by the index, the Dow Jones Industrial Average (DJIA).
The Dow Jones Industrial Average
Before we go any further you need to know what an index is. For our purposes, think of an index as a basket of stocks or another type of security used to track a specific part of the market. Confusing? Stay with me here and it’ll make sense soon enough.
The Dow Jones index is made up of 30 well-established companies that are traded on the Nasdaq & the New York Stock Exchange.
The stocks included are price-weighted meaning that the stocks are weighted in proportion to their price per share.
The higher the price of the stock the greater the weight it has in the index.
The 30 companies that make up the Dow are selected by the Averages Committee, which is made up of Wall Street Journal editors. Examples include 3M, McDonald’s, Verizon & Wal-Mart.
To get the DJIA quote you add up the prices of all 30 stocks and divide it by a divisor (not 30).
The divisor is constantly changing to take into account all the changes that can occur with a stock price, for example a stock split.
How The Dow Quote Is Calculated: An Example
On Dec. 15, 2014 the DJIA closed at 17,180.84 down 99.99 points. If you want to know how quote is calculated, keep reading.
To get the 17,180.84 number, add up the closing prices of all 30 stocks. You should come up with 2,675.33.
Then divide that number by the divisor which can be found in the Wall Street Journal. On that day, the divisor was 0.15571590501117.
You end up with DJIA’s closing value, 17,180.84.
(2,675.33/0.15571590501117) = 17,180.84 at close on December 15, 2014
Knowing this number and its movements is supposed to give you an idea of how the overall stock market is doing but there’s a huge problem with this.
The Problem With The Dow Jones Industrial Average (DJIA)
You’ve probably already figured out the biggest problem with the DJIA, it covers so few companies.
There are a little over 5,000 companies listed on U.S. stock exchanges, and with the index only including 30 companies, too many companies are left out for the index to be truly indicative of how the economy is doing.
A better gauge would be the S&P 500 index. As the name implies it covers 500 companies and gives you a little bit more diversification than the Dow.
This doesn’t mean you should discount the Dow altogether. It is a very rough gauge of the overall market and generally when people say how’s the market doing, they are referring to the Dow.
Your Financial To-Do: Knowing investing terminology will not only help you understand the economy but your individual accounts as well. Just keep in mind that there are better indicators available than the Dow to use as a gauge for the overall stock market.